Valuation-Informed Indexing Either Valuations Matter Not at All or They Matter a Great Deal Indeed

September 7, 2010 at 8:11 amby

by Rob Bennett

We have been living in a twilight zone for the past 30 years.

University of Chicago Professor Eugene Fama’s Efficient Market Theory became the dominant academic explanation of how stock investing works in the 1960s. It was incorporated into the Buy-and-Hold Model, which became extremely popular during the huge bull market. But while the bull was raging forward Yale Professor Robert Shiller published research showing that valuations affect long-term returns. That means that overvaluation is a meaningful concept.

Both things cannot possibly be so.

If the market is efficient, there can be no overvaluation. For the market to be overvalued is for it to be mispriced. For the market to be efficient is for it to be priced properly. People who believe in market efficiency should strike the words “overvaluation” and “”undervaluation” from their vocabularies.

Things have reached a point at which we need to decide once and for all whether Fama is right or Shiller is right. We can fudge this no longer. If overvaluation is real, millions of middle-class people are investing their retirement money pursuant to some very dangerous advice.

Today’s retirement studies report a single safe withdrawal rate for retirements beginning at all possible stock valuation levels. But if overvaluation is real, the safe withdrawal rate that applies at the top of a bull should be roughly one-sixth of the safe withdrawal rate that applies at the bottom of a bear; stocks were priced at one-half fair value in 1982 and at three times fair value in 2000. If the safe withdrawal rate at bear bottoms is six times larger than what it is at bull tops, retirement planners are using wildly wrong numbers (sometimes numbers too high and sometimes numbers too low) most of the time.

The same problem applies in regard to asset allocation advice. A regression analysis of the historical stock-return data indicates that the most likely annualized 10-year return at the prices at which stocks were selling in 1982 was 15 percent real. At the prices that applied in 2000, the most likely annualized 10-year return was a negative 1 percent real. There is no one stock allocation that makes sense in both sets of circumstances. Yet Buy-and-Holders advise investors to stick with the same stock allocation at all times.

The conventional thinking on risk is also wildly off the mark in the event that Shiller is really onto something. The Buy-and-Hold Model (rooted in the Efficient Market Theory) posits that stocks pay higher returns than other asset classes because there is more risk in investing in stocks and stock investors are being compensated for taking on that risk. But, to the extent that valuations affect long-term returns, long-term stock returns are predictable. Stocks can be risky in a post-Shiller world. But to the extent that returns are predictable, risk is optional. High returns are not a reward for taking on risk, under this model. Instead, risk is a penalty for refusing to consider valuations when setting one’s stock allocation.

If the market truly is efficient, Buy-and-Hold makes sense. If not, it doesn’t. This is an either/or proposition. We need to face up to that and either reaffirm the Buy-and-Hold Model or reject it out of hand.

I vote for rejecting it out of hand.

I am not aware of any reason for believing that the market is efficient. The efficient market concept was an hypothesis that failed the test when Shiller showed that valuations affect long-term returns. Buy-and-Hold failed as an intellectual matter in 1981. It has remained popular because The Stock-Selling Industry continued to promote it aggressively and because middle-class investors fell in love with it during the huge bull. The bull is now over and people are looking for explanations of what went wrong. The explanation that explains everything is that we made a huge mistake in continuing to promote Buy-and-Hold for three decades after the academic research showed that it cannot possibly pan out.

We need to examine these questions. We need to revisit the root questions of investing analysis. We need to ask — What if Fama is wrong and Shiller is right? How would that change how we think about risk? How would that change how we go about retirement planning? How would that change how we go about setting our stock allocations?

The stock crash has opened the minds of many investors to ideas that they were not willing to give a hearing to prior to September 2008. I believe that that is going to end up being a positive development for all of us. We need to be questioning all that we once thought we knew for sure about how stock investing works.

Shiller’s 1981 findings led us to the threshold of a Brave New World of stock investing. We have held off making the leap to this exciting new world for 30 years. It’s time.